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Dividend stocks are everywhere, but many just downright stink. In some cases, the business model is in serious jeopardy, or the dividend itself isn't sustainable. In others, the dividend is so low it's not even worth the paper your dividend check is printed on. A solid dividend strikes the right balance of growth, value, and sustainability.
Today, and one day each week for the rest of the year, we're going to look at one dividend-paying company that you can put in your portfolio for the long term without too much concern. This isn't to say these stocks don't share the same macro risks that other companies have, but they are a step above your common grade of dividend stock. Here is last week's selection.
This week, we're going to take a look into the precarious world of mortgage REITs, and I'll show you why Annaly Capital Management (NYSE: NLY ) is an income-producing stock you can trust.
If you run a stock screen right now for the market's highest-yielding companies, chances are you're going to get a handful of mortgage REITs with double-digit yields. Although this may look like free money, it's not that simple; there are attached risks associated with the sector.
Mortgage REITs profit from the difference between the rate at which they borrow, which is currently near record lows, and the rate at which they relend. That difference, known as the net interest margin, has shrunk in recent quarters, but is still a healthy 1.5% to 3% for most of the mortgage REIT sector. This margin is what has allowed these REITs to pay out such delectable dividends.
Where the concern comes in for investors is how mortgage REITs like Annaly, American Capital Agency (Nasdaq: AGNC ) , and Two Harbors Investment (NYSE: TWO ) have used considerable leverage to magnify their 1.5% to 3% margins. These three companies carry debt-to-equity ratios of 598%, 855%, and 422%.
While leverage in itself isn't necessarily bad, ultimately, it could cause a serious problem if interest rates begin to move higher at a rapid pace and those REITs that are most highly levered are forced to exit their positions all at once.
Another concern is that some mortgage REITs are prone to issuing shares to grow their portfolios even as they pay out more in dividends than free cash flow or net income. Chimera Investment (NYSE: CIM ) is one such company that recently pulled off this maneuver. That's often a short-term, dilutive solution that could lead to a dividend decrease sometime in the near future.
Finally, there's the concern that many newer REITs are getting in over their heads. ARMOUR Residential (NYSE: ARR ) is a relatively new player to the mortgage REIT sector, yet it's taken on more than $12.7 billion in additional assets in less than four years. That's a scary amount for what I consider to be a very young company.
Here's why you buy
With so many possible problems then, why on Earth should you consider Annaly Capital Management?
First, it's made serious strides to reduce its leverage, unlike many of its peers. Because of that leverage reduction shareholders will net a slightly lower yield, but its free cash flow is enough to cover that yield! That hasn't stopped the share issuances, unfortunately, but it's good to know that Annaly's free cash flow alone could cover its current yield of 13.2%.
Second, even when interest rates rise, which is inevitable, Annaly is going to be in better position to yield more than its peers because of the actions it's taking now. As you can see below, its yield hasn't dipped below about 4% at any time over the past decade, even with the federal funds rate as high as 6% at one point (though keep in mind that won't necessarily make shareholders immune to a declining stock price).
Finally, the Federal Reserve has given the mortgage REIT sector the all-clear to rake in their profits and begin winding down their positions by stating its intentions to leave the Fed Funds target at 0%-0.25% at least throughout most of 2014. Since mortgage REITs reap their biggest benefits when rates are low, the Fed pretty much gave this sector an additional two-year pass of, probably, double-digit yields.
Here's a quick look at how Annaly Capital has rewarded its shareholders over the past decade:
Even at its lowest yield of about 4%, Annaly Capital still outpaced inflation, netting its shareholders a nice return. Since Jan. 1, 2002, the nominal price of Annaly's stock has hardly budged because of share offerings, but its dividend payback would have shareholders up by 224%!
Annaly Capital Management isn't going to fit into the typical mold of dividend stock featured in this series as it doesn't have set payouts -- they can rise and fall from quarter to quarter. However, it does have a history of outperforming inflation and appears to be a far safer mortgage REIT selection than its more heavily levered peers. The Fed has given us a two-year head start on what will probably be a double-digit yield.
If you're craving even more dividend ideas, I invite you to download a copy of our latest special report, "Secure Your Future With 9 Rock-Solid Dividend Stocks," which is loaded with income-producing companies hand-selected by our top analysts. Best of all, this report is free, so don't miss out!